The dangers of a bloated ECB balance sheet

April 20, 2012

Central balance sheets across the industrialized world have increased rapidly in response to the financial crisis, as recently noted on this blog. In Europe, the balance sheet of the ECB and the 17 national central banks that share the euro currency has grown to around 3 trillion euros after the ECB injected more than a trillion into the market in 3-year loans and loosened its collateral standards.

At above 30 percent of gross domestic product, the ECB’s balance sheet has overtaken that of the Bank of Japan, which has been grappling with deflation for some two decades and started from a much higher level. It is also bigger than that of the U.S. Federal Reserve, which has aggressively responded to two financial crises in five years by tripling the size of its balance sheet to nearly $3 trillion today.

Historically, a central bank’s job is to maintain price stability and the value of its currency. The ECB’s non-standard measures have aimed to do just that as the euro zone debt crisis threatened the viability of the euro currency. But a growing and deteriorating balance sheet also comes at a price.

Julian Callow, head of international economics at Barclays explains:

The more the balance sheet rises, the more the ECB has exposure to the euro zone banking system, particularly of course the banking system in countries which are having difficulty in generating private sector financing.

Indeed, domestic banks in countries like Spain and Italy are deemed to have used cheap ECB financing to buy their country’s debt and benefit from a carry trade, by borrowing at one percent and investing in debt yielding between five and six percent currently. At the same time, the ECB repeatedly loosened the rules on what it accepts as collateral – the assets banks provide as insurance to borrow against the central bank.

In this way, domestic banks could use the debt they bought with ECB funding as collateral when borrowing further from the ECB even though as Elwin de Groot, senior market economist at Rabobank says:

(This) can’t go on indefinitely because you have to post collateral that is worth  more than the amount of cash that you are obtaining from the ECB.

Open Europe think tank estimates the ECB has exposure worth 917.61 billion euros to weaker eurozone economies, according to the latest available data, compared to 444 billion euros a year ago, using data compiled from the balance sheets of the national central banks. That includes 214 billion euros worth of exposure through its bond-buying Securities Markets Programme and 703.61 billion euros in loans dispersed to peripheral banks through its unlimited liquidity provisions, including the LTROs.

Raoul Ruparel, head of economic research at the think tank says:

Given the financial state of these countries – and the banks within them – it is clear that the ECB now owns billions of high risk debt.

Market participants say that it would take a long time for these dangers to filter through to financial markets – if they ever do. They say the central bank has unlimited scope to provide liquidity and print money. That it also has plenty of gold on its balance sheet to offset the accumulation from risky peripheral bonds.

Only in an extreme scenario — like in the case of a Spanish default — could things deteriorate to the point that the ECB may take a hit, Rabobank’s de Groot added.

But others have begun raising concerns. And if the extreme scenario does materialize, things in Europe could quickly deteriorate.

Barclays’ Callow:

It’s like a piece of blue-tack that you keep pulling and it can stretch and stretch and stretch but the problem is that when it does snap, then you have a real problem. Snap in this case means a loss of confidence in the currency and that’s corrosive for any central bank that has a paper currency. The ECB has got to be very careful about extending too far because of the potential dangers to its credibility.

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